When people trump capital

By Michael Cooper

50 years ago it wasn’t difficult to pinpoint where a company created its value – it tended to be where its machinery was located. Today, in the world of complex multinationals, continual innovation and service companies, it’s rather more difficult to tell.

That’s why people are suddenly talking about transfer pricing. The OECD has said that one of the central motivations of its BEPS project is to align the profits of multinationals with their value-creating activities.

When it comes to intellectual property (IP) and other intangibles, this is easier said than done – which is why the OECD’s proposals on transfer pricing will be one of the most difficult to resolve.

Companies currently apply the ‘arm’s length’ rule to transfer pricing, where they imagine what two independent and unconnected companies would do in the same situation and apply that cost structure.

The issue that the OECD are seeking to address is where valuable IP is held in low tax territories, with limited commercial activity, and other group companies in higher tax territories have to pay to use that IP. So the profits in the low tax territory increase while those in the higher tax jurisdictions are reduced, even though that is where much of the commercial activity is happening.

The OECD’s solution to this is to suggest that the IP-owning company is only going to be allowed to keep the lions’ share of the associated profit if it has ‘substance’, i.e. the company employs people who make the critical decisions regarding the IP. If the people who make the decisions aren’t in the same place as the capital investment in the IP, under the OECD’s proposals the profit will be reallocated to where the people are. In other words, people trump capital investment and legal ownership.

The OECD doesn’t go into details about how this will work but seems to be pushing towards the parties dividing the profits between them rather than one paying a set fee to the other. What is clear is that achieving these aims will be complex and often subjective, and that the ramifications for many groups will be significant. We can expect more detail on this in the coming months with the draft OECD papers on risk shifting and excess capital.

In the meantime the direction of travel is clear and multinationals must now begin the task of reviewing their legal and operating structures to identify areas of potential risk and develop plans to mitigate these. Given that in many cases this will involve changes to the elements of the operating model, early identification of issues and engagement with the wider organisation will be critical.

Visit our web page for more detailed insights on these issues by my colleague Ian Dykes from our transfer pricing practice.